A survey on electricity market design: Insights from ...

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WORKING PAPER SERIES IN PRODUCTION AND ENERGY

A survey on electricity market design:

Insights from theory and real-world

implementations of capacity

remuneration mechanisms

By Andreas Bublitz, Dogan Keles, Florian Zimmermann,

Christoph Fraunholz, Wolf Fichtner

No. 27 | February 2018

A survey on electricity market design:

Insights from theory and real-world implementations

of capacity remuneration mechanisms

Andreas Bublitz*, Dogan Keles, Florian Zimmermann,

Christoph Fraunholz, Wolf Fichtner

Chair of Energy Economics, Institute for Industrial Production (IIP),

Karlsruhe Institute of Technology (KIT),

Hertzstraße 16, 76187 Karlsruhe, Germany

*Corresponding author. Email address: [email protected]

Tel.:+49 721 608 44544

Electricity markets are currently going through a phase of agitating transition, which is

mainly characterized by an increasing share of fluctuating renewable energies. Among

policy makers, this has led to growing concerns about generation adequacy and often

to the introduction of different capacity remuneration mechanisms to generate less

volatile sources of income for investors and, thereby, guaranteeing generation

adequacy. However, these mechanisms entail new challenges regarding the best

design to avoid any adverse effects. At the same time, it is disputed whether capacity

remuneration mechanisms are indeed needed or whether an energy-only market

is sufficient. Therefore, after discussing the peculiarities of the electricity markets, which

are the starting point of the unique regulatory framework, an up-to-date overview of the

debate on the need for capacity remuneration mechanisms is provided. In addition, the

current status of capacity remuneration mechanisms in Europe is shown, and initial

experience is presented. Furthermore, this article reflects the current state of research

about capacity remuneration mechanisms in regards to, for example, cross-border

effects, investment cycles or market power. In a conclusive summary, shortcomings of

the existing research works and open questions that need to be addressed in future

works are discussed.

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Since working papers are of preliminary nature, it may be useful to contact the author of a

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A survey on electricity market design: Insights fromtheory and real-world implementations of capacity

remuneration mechanisms

Andreas Bublitza,∗, Dogan Kelesa, Florian Zimmermanna, ChristophFraunholza, Wolf Fichtnera

aKarlsruhe Institute of Technology, Chair of Energy Economics,Hertzstraße 16, D-76187 Karlsruhe

Abstract

Electricity markets are currently going through a phase of agitating tran-sition, which is mainly characterized by an increasing share of fluctuatingrenewable energies. Among policy makers, this has led to growing concernsabout generation adequacy and often to the introduction of different capac-ity remuneration mechanisms to generate less volatile sources of income forinvestors and, thereby, guaranteeing generation adequacy. However, thesemechanisms entail new challenges regarding the best design to avoid anyadverse effects. At the same time, it is disputed whether capacity remu-neration mechanisms are indeed needed or whether an energy-only marketis sufficient. Therefore, after discussing the peculiarities of the electricitymarkets, which are the starting point of the unique regulatory framework,an up-to-date overview of the debate on the need for capacity remunerationmechanisms is provided. In addition, the current status of capacity remu-neration mechanisms in Europe is shown, and initial experience is presented.Furthermore, this article reflects the current state of research about capacityremuneration mechanisms in regards to, for example, cross-border effects,investment cycles or market power. In a conclusive summary, shortcomingsof the existing research works and open questions that need to be addressedin future works are discussed.Keywords: Electricity market, Market design, Generation adequacy,

∗Corresponding authorEmail address: [email protected] (Andreas Bublitz)

Capacity markets, Capacity remuneration mechanisms

1. IntroductionA reliable electricity system remains one of the main objectives of energy

market regulators, especially after liberalizing the sector, whereas marketparticipants are now responsible for investments in supply capacities. Thisobjective requires the stimulation of adequate investments on the supply sideby market prices, which are to be high enough to finance not only the opera-tional but also the fixed costs. However, as experienced in Europe, generatingadequate price signals becomes more and more challenging during the energytransition phase, which is mainly shaped by three factors: the expansion ofrenewable energies, the reduction of carbon emissions from fossil power pro-duction and the European market integration. In this transition period,electricity prices have strongly decreased. Besides other factors, the risingfeed-in from volatile renewable energy sources (RES) with marginal genera-tion costs near zero has strongly contributed to this development (Kallabiset al., 2016; Bublitz et al., 2017).

Furthermore, a reliable electricity system needs to be reached at rea-sonable costs for end consumers while at the same time greenhouse gasesand other emissions are limited to a certain level. These three targets ofelectricity market regulation—reliability, sustainability, and affordability—are commonly named the energy trilemma (Ang et al., 2015; Hawker et al.,2017), as an efficient balance between these oftentimes conflicting targetsis difficult to find and achievable only by accepting trade-offs. However,in practice it looks as if reliability is the trump card in the debate, wherethe objective is to maintain the high level of security of supply reached inindustrialized economies without restrictions (European Commission, 2006;BMWi, 2017), leaving the relative weights given to sustainability and afford-ability the only thing that remains to be decided (Newbery, 2016b). Thechallenging trade-off between reaching the set targets of sustainability andaffordability is usually made by pricing emissions through dedicated cap andtrade schemes, such as the EU Emissions Trading Scheme.

Initially, several exchanges and pool markets were established, on whichespecially energy quantities were traded forming the energy-only market(EOM). The short-term objective of the EOM is to allocate resources op-timally (e.g., Gan and Litvinov, 2003) and to ensure a cost-minimal supply

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with prices reflecting marginal costs of electricity production, whereas its taskin the long-term is to guarantee the demand-supply adequacy by generatinginvestment signals provided by peaking prices at scarcity times (Stoft, 2002;Hogan, 2005). However, motivated by the missing money problem, there isstill an ongoing discussion about the ability of the EOM to fulfill these ob-jectives in general (Cramton et al., 2013; Joskow, 2008). In the recent years,the discussion became even stronger due to the expansion of RES electricitygeneration (Hildmann et al., 2015).

Due to the already large and still quickly growing number of studies on ca-pacity remuneration mechanisms (CRMs)1, it is increasingly hard to keep anup-to-date overview. As several real-world experiences in the implementationand administration of CRMs have been gained, reviews have already beencarried out focusing on the practical lessons learned (e.g., Batlle and Rodilla,2010; Beckers et al., 2012; Bhagwat et al., 2016b; Karacsonyi et al., 2006;Spees et al., 2013). However, due to the rapid development and frequent reg-ulatory changes, some of the presented information is already obsolete. Othermore broadly oriented studies provide a systematic description of CRMs aswell as a descriptive comparison (e.g., Doorman et al., 2016; DNV GL, 2014;European Commission, 2016b; Hancher et al., 2015; de Vries, 2007) or fo-cus on the fundamental economic principles of CRMs, (e.g., Cramton et al.,2013; Stoft, 2002). Beside these review documents on theoretical concepts ofmarket design and CRMs as wells as a review of mechanisms implementedin some countries, to the knowledge of the authors, there still does not ex-ist any comprehensive review on the discussion about and the assessment ofdifferent design options for the electricity market in the literature.

Hence, this article aims to guide newcomers and interested researchersthrough the complex field of electricity market design by providing a broadand up-to-date survey starting with the discussion about the necessity ofalternatives to the EOM (Section 2). Afterward, the focus is set on the as-sessment of market design options in the literature, both from a practicalperspective and theoretical perspective. In the practical case, implementedmarket design options in different European countries (Section 3) are dis-cussed, as many changes to existing market designs could be observed in

1In the literature, two other terms—capacity mechanism and capacity markets—arecommonly used as synonyms for capacity remuneration mechanisms. In this article, how-ever, capacity markets have a narrower definition and are considered as a specific variantof the different mechanism to enumerate capacity (see 3).

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Europe in the last years. The theoretical perspective considers the assess-ment of the impacts of different design options (Section 4) on regulatorytargets, such as generation adequacy and RES integration. The review ofthe latter perspective will be carried out in focusing on the qualitative dis-cussion of limitations and benefits of each market design option, as well ason the model-based analysis of impacts on different criteria, e.g., market wel-fare, security of supply or incentivizing flexibility. Finally, the main commonfindings are discussed, open questions with which researchers are currentlyconfronted are pointed out, and a set of policy implications is derived (Section5).

2. The on-going debate about securinggeneration adequacy

The electricity sector is characterized by a particular set of features dis-tinguishing it from other sectors often viewed as unique and problematicas these features act as barriers complicating the formation of an efficientmarket equilibrium between demand and supply in the short term and, evenmore so, in the long term (Borenstein, 2002; Joskow and Tirole, 2007). Thesebarriers mainly originate from the physical properties of the electricity sys-tem as well as specific market properties and have raised growing concernsregarding generation adequacy2.

In the recent years, especially European policymakers are worried whetherthe existing markets will generate sufficient price signals to incentivize in-vestments in generation capacity and to ensure security of supply (Leautier,2016). However, the question remains whether these concerns are justifiedand if the already introduced instruments are effective and efficient. There-fore, after describing the long-standing barriers (Section 2.1) and more recentchallenges (Section 2.2) that lead to numerous adaptations of the existingmarket design, the current state of the debate on market design is presented(Section 2.3).

2Generation adequacy has a long-term orientation and is defined as the ability of anelectricity system to provide sufficient capacities to satisfy the base as well as the peakdemand at all times (European Commission, 2017a). Furthermore, generation adequacyalso includes the ability to provide sufficient flexibility to follow sharp load changes (Brijset al., 2016).

4

2.1. Existing barriers to generation adequacyThe barriers in the electricity sector can be clustered in physical and

market-related ones. Physical barriers are mainly based on the fact thatelectricity systems need to balance generation and consumption in each nodeof the electricity grid at every point in time, as the disruption of electricityfrequency can lead to severe damages, such as the destruction of connecteddevices or even the collapse of the entire power system (Kwoka and Madjarov,2007). Usually, the most substantial amount of electricity is already tradedseveral months or years in advance via forward contracts and over-the-counter(OTC) markets that allow energy suppliers to hedge their portfolio (Meeuset al., 2005). As the possibilities to store electricity economically are stilllimited, and deviations from the expected consumer demand as well as theunexpected unavailability of generation capacity induce a need for short-term trading, spot markets usually possess high liquidity. However, as acertain time between spot market clearing and fulfillment is still necessary toorganize the delivery, current wholesale markets are unable to capture thesetemporal and spatial requirements in their clearing process. Hence, othermarket or regulatory mechanisms are required. Furthermore, due to thenature of the electricity network, a free-rider problem occurs as up to now thenetwork cannot differentiate between customers with and without contractsguaranteeing a reliable supply (Lynch and Devine, 2017). Therefore, an EOMdesign without reliability contracts cannot discriminate between customerswho are willing to pay for reliability and those who are not (Joskow andTirole, 2007). These technical properties are one reason why electricity pricesas the outcome of market equilibrium cannot carry all information and signalsnecessary for the reliable long-term operation and the required investmentsin the generation infrastructure. Other reasons, which are briefly discussedin the following, stem from the market organization itself.

One problem in current wholesale electricity markets is that large partsof electricity demand are inelastic from a short-term perspective, e.g., house-holds have a fixed rate for energy consumption in combination with a baserate tariff (Dutschke and Paetz, 2013) and, thus, do not actively participatein the volatile wholesale market or show any reaction even to drastic priceschanges (Cramton and Stoft, 2005). Therefore, the marginal costs of baseload and with increasing demand peak load power plants set the marketprice until the entire demand can no longer be met by the existing gener-ation capacity (see Figure 1a). For this reason, Lynch and Devine (2017)

5

merit-order curve

demand

p

p∗

infra-marginal rent

scarcity rent

capacity

price

a)

merit-order curve

p∗ = p

demand

missing money

scarcity rent

infra-marginal rent

capacity

price

b)

Figure 1: Price setting in scarcity situations. a) The equilibrium price p∗ is below theprice cap p and an efficient outcome is achieved. b) The equilibrium price p∗ is above theprice cap p, however, as the resulting price p∗ is equal to the price cap, welfare loses occur(missing money).

state that the price signal for reliable supply and generation adequacy canbe considered weak. Keppler (2017) even argues that many problems regard-ing security of supply could be solved if the demand side became more elasticand participated in the market efficiently. Furthermore, Aalami et al. (2010)claim that the implementation of demand response programs will lead to thereflection of wholesale prices in retail prices, especially, if new developmentschange the need for electric services and new business models are developedfor the demand response measures. However, currently, the main burden ofbalancing the system to guarantee the reliable operation of the electricitygrid in the short term and to ensure generation adequacy in the long termlies on the supply side.

6

Price caps in spot markets3 are a regulatory barrier introduced to protectconsumers and to avoid the abuse of market power in the absence of demandelasticity (Stoft, 2002). However, as Petitet et al. (2017) point out, price capsare usually set below the value of lost load (VoLL)4 for political reasons, andthe resulting investments in generation capacity are likely not sufficient tocover the electricity demand at all times. Even though it is theoreticallypossible to set shortage prices or price caps sufficiently high, i.e., equal tothe VoLL, in practice its specific value would have to be determined first—atask often described as difficult or even impossible to perform (e.g., Cramtonet al., 2013; Willis and Garrod, 1997).

Therefore, other measures may be required to replace signals coming fromprice spikes and to generate sufficient incentives for investments (Doormanet al., 2016). These additional measures are to be implemented to addressthe so-called missing money problem, which can be defined as the lost earn-ings beyond the price cap, especially for peak load power plants (see Figure1b). More detailed, missing money is that part of these lost earnings that isnecessary to cover the investment and all other fixed costs. For Joskow andTirole (2007), missing money may also occur due to premature technical de-cisions of system operators to avoid market disequilibrium and brownouts5.Furthermore, Newbery (2016a) argues that even if earnings from price spikesare sufficient to cover fixed and capital costs, investors might not be willingto bear the associated risks and are unable to lay them off through futuresand contract markets. In this case, the problem is referred to as missing

3Whereas in some countries price caps are set directly by the regulator and are legallybinding, e.g., Texas ERCOT day-ahead market 9000 USD/MWh (Public Utility Commis-sion of Texas [PUC], 2012), in other countries only a technical limit exists. For example,the limit for the French day-ahead market at the EPEX SPOT is 3000 EUR/MWh (EPEXSPOT, 2018), and for the Spanish daily market at the OMIE the limit is 180 EUR/MWh(OMI-Polo Espanol [OMIE], 2018). However, for over-the-counter trading, a higher pricecan be specified.

4The value of lost load describes the average willingness of customers to pay for thereliability of their electricity supply. The individual willingness to pay is not an unlimitedvalue but can vary between close to zero and tens of thousands of Euros per MWh,especially for critical infrastructures such as hospitals (Hogan, 2017).

5 In the electricity system major failures result in brownouts or blackouts. A blackoutis a disruption in a wider range of an electricity system up to a total collapse of thewhole supply whereas a brownout implies an excessively reduced voltage that can resultin equipment failure, e.g., overheating of electric motors (Blume, 2007).

7

market instead of missing money (Newbery, 1989).

2.2. Recently emerging challengesIn addition to the already mentioned long-standing barriers that exist on

wholesale electricity markets, several recent developments revive the debateabout mechanisms remunerating generation capacity, e.g., the rise of inter-mittent RES or the market-related and political uncertainties, such as thephase-out of specific technologies. The aim of the following paragraphs is,thus, to shed light on these developments.

Driven by the introduction of various subsidy programs, RES have expe-rienced a remarkable rise6. Based on the regionally varying policy targets, forexample, the ambitious EU-wide target of attaining a share of 20% renewableenergy in the final energy consumption by 2020, a further expansion of PVand wind power capacities is expected. PV and wind power are highly capitalintensive (e.g., Newbery, 2016b; Schmidt, 2014) but feature marginal costsclose to zero (Milligan et al., 2016; Osorio and van Ackere, 2016). The lowgeneration costs of RES result in decreasing electricity prices—also known asthe merit-order effect (Sensfuß et al., 2008). Lower electricity prices in turnreduce the yields of conventional generation and, at the same time, the largershare of RES decreases the load factors of thermal capacities. Combined withthe priority dispatch of RES implemented in many European countries (Huet al., 2017; Newbery et al., 2017), this effect can even lead to negative prices(Nicolosi, 2010). Furthermore, as scarcity situations occur less often, renew-able generation reduces the profitability of peak-load plants that depend onrecovering their capital costs during a limited number of hours (Keppler,2017). In Europe, the expansion of RES in combination with several otherfactors, e.g., decreasing prices for hard coal and carbon emission certificates,caused a significant drop in electricity prices (see Bublitz et al., 2017; Hirth,2018; Kallabis et al., 2016) that drastically complicated the recovering of op-erating expenses for conventional capacities (see Figure 2). For instance, inthe last years, gas-fired generation was often unprofitable. As a consequencegas power plants are being mothballed and decommissions are already carried

6The rise of RES is, for example, illustrated by the fact that between 2006 and 2016,the worldwide installed photovoltaic (PV) and wind power capacity grew by a compoundannual rate of 48% respectively 21% to a worldwide installed capacity of 303 GW respec-tively 487 GW by the end of 2016 (REN21, 2017)

8

20082009

20102011

20122013

20142015

20162008

20092010

20112012

20132014

20152016

20082009

20102011

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4348494743

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38333229

Avg.

day-

ahea

dpr

ices

[EU

R/M

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Figure 2: The development of day-ahead prices in major European markets in the lastyears shows a clear downward trend, apart from the years 2009 and 2010, which can beregarded as outliers due to the impact of the global economic crisis. The comparison of thefigures for 2008 and 2016 indicates a decline of about 50% in Germany, France, and Italy,whereas the decline in Spain is about 33%. Sources: ENTSO-E (2017); EPEX SPOT(2018); Gestore dei Mercati Energetic (2017); OMI-Polo Espanol S.A. (2017).

out or being considered (S&P Global Platts, 2013; Bloomberg, 2015; Reseaude transport d’electricite, 2014b).

Due to the dependence on weather conditions, the generation of PV andwind power is highly intermittent, and especially wind generation is hard topredict (Newbery, 2016b). As their level of electricity generation is semi-dispatchable— only a reduction is possible (Lynch and Devine, 2017; DiCosmo and Lynch, 2016), an additional need for flexibility is created, which,for example, can be provided by demand response measures, large-scale stor-age capacities or power plants with the ability to quickly ramp up or down(Pollitt and Anaya, 2016; Cepeda and Finon, 2013). Therefore, withoutfurther advancements, intermittent RES are currently unable to replace dis-patchable conventional power plants adequately (Hach et al., 2016; Doormanet al., 2016) and the need for dispatchable generation capacity remains high(VDE, 2012). Moreover, as RES are often located away from the demandcenters and the locations of capacities they replace, grid constraints will playa more pronounced role. RES are already mentioned as the main driver forgrid congestions (Bruninx et al., 2013), and in the future, supply and de-mand need to be balanced at different geographical levels, e.g., at the local,

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Figure 3: Operating years since the beginning of operation of installed conventional ca-pacities. While large capacities in Germany and France are operating for more than 30years, in Italy and Spain, the installed capacity of the power plant fleet in the category10–20 years is higher than the installed capacity in the category of more than 30 operatingyears.

the national or supranational level. Owing to the aging power plant fleet(see Figure 3), there does not only seem to be a need for maintaining currentconventional capacities but also to invest into new units as a large share ofthe existing units reaches the limits of their technical lifetime.

Finally, investors face different uncertainties regarding fuel and electric-ity prices and the regulatory framework, e.g., the nuclear phase-out decision,fossil fuel reduction or carbon emission targets. Whereas the nuclear phase-out contradicts the targets of lowering the carbon emissions, the discussionsabout a phase-out of hard coal and lignite-fired power plants are in accor-dance (e.g., Knopf et al., 2014; Bruninx et al., 2013). Even though the phase-outs affect supply security, Becker et al. (2016) claim that neither politiciansnor scientists discuss lowering the level of security of supply to achieve asustainable and affordable system. Beyond that, in case of an investmentdecision, the prompt commissioning of generation capacity—especially forcontroversial technologies (e.g., carbon capture and storage)—proves to beanother obstacle, as the licensing process is tedious and adds another layerof uncertainty (Doorman et al., 2016). In conclusion, it can be said thatinvestors are exposed to major uncertainties as a result of the described de-

10

velopments, which are further exacerbated, e.g., by volatile energy prices, thegrowth of e-mobility and the transfer of clean electricity into other sectors(sector coupling). Hence, the question arises whether the required invest-ments in conventional capacities can be handled within the existing marketdesign under the present uncertainties.

2.3. The optimal functioning of energy-only marketsand the necessity of capacity remunerationmechanisms

The scientific discussion on the necessity as well as the design of CRMsarose in the 1990s, a decade that marks the beginning of the restructuring7 ofelectricity markets in many countries around the world (e.g., Hogan, 2002),where the first approach chosen often was to rely on the scarcity pricingof energy and, thus, EOMs were established (Sioshansi and Pfaffenberger,2006).

One, maybe the most persuasive, argument in favor of an EOM is that—even in the absence of an active demand response—resulting market pricesare efficient and, thus, lead to sufficient long-term investments guaranteeingthe least-cost long-term system if several key assumptions are met (Carama-nis et al., 1982; Oren, 2005; Schweppe et al., 1988; Stoft, 2002): (1) the marketis perfectly competitive, (2) market participants have rational expectationsand (3) follow a risk-neutral strategy. However, in the light of the presentstate of electricity markets that feature several imperfections (Cepeda and Fi-non, 2011), these assumptions seem rather unrealistic, maybe even impossibleto realize in practice. In real-world markets, a small number of producers of-ten dominate the market, resulting in a duopoly or oligopoly (e.g., Schwenen,2014), and invest strategically (Grimm and Zottl, 2013; Zottl, 2010). Further-more, investors are usually rather risk-averse, i.e., building less capacity thanrisk-neutral investors would (Neuhoff and de Vries, 2004). Moreover, marketparticipants may not always have rational expectations, and in the presenceof the large uncertainties, e.g., about the development of electricity prices,and the long lead times for new investments, electricity markets are prone

7In this context, in comparison with deregulation, restructuring is the better fittingterm as the electricity sector serves as a prominent example, where the replacement of amonopoly with competitive market structures does not lead to less extensive, only to adifferent regulatory framework (Jamasb and Pollitt, 2005; Newbery, 2005; Vogel, 1998).

11

to suffer investment cycles (Arango and Larsen, 2011; Ford, 2002; Olsinaet al., 2006). The alternation between overcapacity and under-capacity re-sults in inefficient market allocations, i.e., in the former case, unprofitableinvestments and, in the latter case, an excessive risk of load curtailment andhigh costs for consumers (Reseau de transport d’electricite, 2014a). More-over, de Vries and Hakvoort (2004) argues that even long-term contracts donot provide a solution as they offer consumers the opportunity to free-ride.8In addition, Keppler (2017) shows two other independent problems of anEOM. On the one hand, demand-side externalities in the form of transactioncosts and incomplete information ensure that the social willingness-to-payis greater than private willingness-to-pay for additional capacity. On theother hand, investments in generation capacities are not arbitrarily scalable,but rather take discrete values. In combination with dramatically lower rev-enues in the transition from under to overinvestment, investors have strongasymmetric incentives and, thus, tend to under- rather than to overinvest.Besides, Joskow and Tirole (2007) argue that scarcity rents are very sensi-tive to regulatory changes and that even minor mistakes are likely to have asignificant impact on market prices.

Some of the more critical voices stress that market imperfections, espe-cially the lack of demand response, will always persist in EOMs, and leadto the exercise of market power, which results in high price peaks. Thus, adifferent framework or additional measures, e.g., CRMs, are required to helpto ensure generation adequacy efficiently (Cramton and Stoft, 2005; Joskowand Tirole, 2007). Others reply that the main problem of EOMs is the lack

8A problem with long-term contracts is that they are not contracted directly betweenconsumers and utilities, but rather through load-serving entities as intermediaries. How-ever, rational consumers prefer the cheapest retailer, which by avoiding long-term contractsdoes not contribute to the financing of peaking capacities.

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of political will to allow for unconstrained electricity prices9 and periodicshortages (Besser et al., 2002; Hogan, 2005).

However, often it is argued that CRM are inefficient and according toOren (2000) the least desirable instrument or according to Hogan (2017)only the third best option to ensuring reliability—with the first option beingthe elimination of the leading underlying causes, e.g., incentivize a flexibledemand10, and the second-best option being an administrative price curve forthe usage of reserve energy. Wolak (2004) even claims that the rationale forCRM is essentially a holdover from the regulated regime of the energy sectorthat encourages over-investment and is highly susceptible to market power,thus, frequently requiring regulatory intervention to set a non-distorted ca-pacity price.

Summing up, whether the EOM is able to guarantee generation adequacyis still discussed intensively. It is, however, apparent that the efficient alloca-tion of resources by an EOM is a highly challenging task, given the particularcombination of the unusual characteristics of the electricity market, i.e., thephysical properties of the product electricity, the required high level of se-curity of supply, the lack of reactivity to real-time prices, and the missingpossibility of individual consumer rationing (Joskow and Tirole, 2007). More-over, the utilization of real-world experience to draw general conclusions isonly of limited use. In case, some analysts argue that the developments ona particular market serve as an example for the inherent shortcomings ofan EOM, advocates respond that the market has not been able to function

9Although price caps are frequently mentioned as a source of the missing money prob-lem, the data on market prices do seem to tell a different story, e.g., since the establishmentof the EEX in 2000, the upper price limit of the German spot market (3000 EUR/MWh)was not once hindering the price formation (EPEX SPOT, 2018), the same seems to bethe case in several US market areas from 2000 to 2006 (Joskow, 2008), and, thus, it seemsrather far-fetched that in the cases price caps are the primary cause of the missing moneyproblem. On the contrary, in France, the price cap has been hit several times, most recentlyon 19 October 2009, although, the main reason arguably lies in a coordination failure, i.e.,a difference of 7000 MW between the consumption and available capacity forecasts re-sulting in less available capacity on the market (French Energy Regulatory Commission,2009).

10In the future, if end consumers start to participate directly in the market via smartmeters, they could specify in detail what price they are willing to pay for each consumptionlevel. If the price is too high, the smart meter will switch off individual consumers directly,for example, the washing machine, while leaving others connected, e.g., the lights andrefrigerator. Thereby, the missing money problem could be avoided (Newbery, 2016a).

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well due to regulatory mistakes (Doorman et al., 2016). Beyond that, Hogan(2017) states that the financial distress present in many European as wellas North American electricity markets, can be attributed to over-capacities.Even though no agreement is found in the literature on the fundamental needfor CRM, recent developments have to such an extent cast doubt on the effec-tiveness of an EOM that in many countries politicians deem the introductionof such mechanisms necessary.

3. Market design options and current statusof implementation in Europe

In this section, an overview of several CRMs currently implemented orin the planning stage in European countries is presented. After briefly in-troducing a general classification and the basic principles of different genericmechanisms, further details of the real-world examples in some of the mostrelevant European countries are described. Based on the presented findings,conclusions from the implemented mechanisms are drawn with a focus on theongoing efforts of creating a single European electricity market.

3.1. Generic market design optionsTypically, CRMs are designed to incentivize investments and thus im-

prove generation adequacy, i.e., avoid shortage situations. This is imple-mented by offering capacity providers income on top of the earnings fromselling electricity on the market (Hawker et al., 2017). Yet, the mechanismsvary in the way the required quantities that are supplied and the correspond-ing capacity prices are determined (Hach et al., 2016).

The European Commission (2016b) distinguishes between volume-basedmechanisms, where a specific capacity sufficient to guarantee the desiredlevel of generation adequacy is set and then results in a market-driven price,and price-based mechanisms, where the amount of the procured capacity issteered by setting a target price. Both categories can also be subdivided intomarket-wide and targeted approaches. Whereas market-wide mechanismsprovide support to all capacity in the market, targeted mechanisms aim atsupporting only a subset, e.g., newly built capacity or capacity expected tobe required additionally to the one already provided by the market. Morespecifically, six different types of mechanisms can be differentiated (for typicalcharacteristics, see Table 1):

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(1) Tender for new capacity. Financial support is granted to capacityproviders in order to establish the required additional capacity. Differentvariations are possible, e.g., financing the construction of new capacity orlong-term power purchase agreements.

(2) Strategic reserve. A certain amount of additional capacity is con-tracted and held in reserve outside the EOM. The reserve capacity is onlyoperated if specific conditions are met, e.g., a shortage of capacity in the spotmarket or a price settlement above a certain electricity price.

(3) Targeted capacity payment. A central body sets a fixed price paid onlyto eligible capacity, e.g., selected technology types or newly built capacity.

(4) Central buyer. The total amount of required capacity is set by a cen-tral body and procured through a central bidding process so that the marketdetermines the price. Two common variants of the central buyer mechanisminclude the forward capacity market (Cramton and Stoft, 2005, 2006) andreliability options (Perez-Arriaga, 1999; Vazquez et al., 2001; Batlle et al.,2007).

(5) De-central obligation. An obligation is placed on load-serving entitiesto individually secure the total capacity they need to meet their consumers’demand. In contrast to the central buyer model, there is no central bid-ding process. Instead, individual contracts between electricity suppliers andcapacity providers are negotiated.

(6) Market-wide capacity payment. Based on estimates of the level ofcapacity payments needed to bring forward the required capacity, a capacityprice is determined centrally, which is then paid to all capacity providers inthe market.

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Table 1: Typical characteristics for different types of CRMs. However, due to specific requirements, the concrete specificationsmay vary in different countries. Sources: European Commission (2016b); Hancher et al. (2015); Neuhoff et al. (2013, 2016)

Type Category Procurement/Market type

Partici-pationin othermarkets

Product Main regula-tory parame-ters

Tender for newcapacity

volume-based/targeted

centralized/auction

yes firm ca-pacity

capacity volume

Strategic re-serve

volume-based/targeted

centralized/auction

no reserve ca-pacity

capacity volume,activation rule,trigger event

Targeted ca-pacity payment

price-based/targeted

centralized/auction

yes firm ca-pacity

capacity price, el-igibility criteria

Central buyer volume-based/market-wide

centralized/auction

yes call option capacity volume,strike price

De-central obli-gation

volume-based/market-wide

decentralized/bilateral

yes reliabilitycertificate

security margin,penalties

Market-widecapacity pay-ment

price-based/market-wide

centralized/auction

yes firm ca-pacity

capacity price

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3.2. Current status of implementationIn the European Union, the member states themselves decide on whether,

when, which and how to implement a CRM (Bhagwat et al., 2017c). Al-though according to Petitet et al. (2017), the EOM remains the EuropeanCommission’s preferred approach to trigger new investments and provide sig-nals for decommissioning in case of overcapacities, several European coun-tries have either already implemented CRMs or are currently in the processof evaluating tailored solutions (for an overview see Table 3). The country-specific approaches differ not only with regard to the chosen type of themechanism but also with regard to the respective administrators and the eli-gible technologies. Further characteristics of the currently active mechanismsare described in the following paragraphs.

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Table 3: Overview of implemented CRMs in Europe. Sources: Cejie (2015); Deutscher Bundestag (2016); EirGrid plc andSONI Limited (2017); European Commission (2014, 2016a,b,c, 2017c,b); Hancher et al. (2015); Patrian (2017); Roques et al.(2017); Single Electricity Market Committee (2016); Svenska Kraftnat (2016).

Type Country Administrator Eligible technologies Status1

TSO RA TPP IRE DSM IC

Strategicreserve

Belgium x x x x active (2014)Germany x x x x planned2 (2018)Sweden x x x active (2003)

Centralbuyer

Ireland3 x x x x x x planned (2017)Italy3 x x x x x planned (2018)Poland4 x x x x x x planned (2018)UK x x x x x x active (2014)

De-centralobligation

France x x x x x active (2015)

Targetedcapacitypayment

Spain5 x x active (2007)

Abbreviations: DSM—demand side management, IC—interconnector, IRE—intermittent renewable energies, RA—regulatoryauthority, TPP—thermal power plant, TSO—transmission system operator1 Year of (planned) implementation in parentheses. 2 In Germany, two separate mechanisms have been discussed that can beclassified as a strategic reserve. In 2016, a security stand-by arrangement for lignite-fired power plants with a total capacity of2.70 GW was introduced in order to attain national climate targets. Furthermore, an additional so-called capacity reserve issupposed to be active in winter of 2018/19 to ensure generation adequacy. However, as the European Commission still assesseswhether the capacity reserve complies with EU state aid rules, it is unclear whether the planned schedule can be met.3 To date, targeted capacity payments are used. 4 Currently, a strategic reserve is implemented. 5 This refers to the nowin place “availability service” mechanism. An additional mechanism named “investment incentive” was abolished in 2016.

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Strategic reserve (Belgium/Sweden)

Both Belgium (since 2014) and Sweden (since 2003) have set up strategic re-serves to support demand peaks during the winter season (Elia Group, 2015;Svenska Kraftnat, 2016). In Belgium, the capacity is procured through acompetitive tendering process, in which market participants intending toshut down capacity are obliged to participate (Hancher et al., 2015). Thusfar (until October 2017), the reserve has not been activated (Elia Group,2017a,b). Contrary, the Swedish reserve has already been used a few times,with yearly costs in 2013 and 2014 amounting to about 14 respectively 13 mil-lion Euro. This is significantly lower than the estimated costs of a shortagesituation (90 million Euro) (Cejie, 2015).

Central buyer (United Kingdom)

In order to maintain generation adequacy, in 2014, the United Kingdom in-troduced central capacity auctions with the first delivery to take place inwinter 2018/2019. The capacity payments are determined via descendingclock auctions four years (T–4) and one year (T–1) before the respectivedelivery period. Despite the technology-neutral approach, the incentives fordemand response (0.4–2.5% of the contracted capacity) and new investments(4.2–6.5%) have been limited in the first three T–4 auctions (Office of Gasand Electricity Markets, 2015, 2016, 2017). However, in the latest T–4 auc-tion (2016), existing and new storage capacities won contracts for the firsttime, accounting for around 6% of the contracted capacity (Office of Gasand Electricity Markets, 2017).

De-central obligation (France)

In 2015, France implemented a de-central obligation with the first deliveryto take place in 2017. All load-serving entities are obliged to hold a cer-tain number of certificates reflecting the share of electricity consumption oftheir consumers during times of peak demand, e.g., when extreme winterconditions occur. Certificates can be obtained by certifying own generationand demand-side capacities, which afterward can be traded in a market orusing bilateral arrangements (European Commission, 2016a). The Frenchmechanism is the first to explicitly include and remunerate foreign capacitiesin neighboring countries, however, limited by the expected capacity of therespective interconnectors at peak times (European Commission, 2016c). In

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the first three auctions, a total volume of 34 GW has been contracted withall auctions resulting in capacity prices close to 10 000 EUR/MW (EPEXSPOT, 2017a,b,c).

Targeted capacity payments (Spain)

The Spanish mechanism, initially introduced in 1997, was substantially re-designed in 2007 to adapt to the then valid European law (Hancher et al.,2015). The new system was designed to reduce investment risk by offeringfixed capacity payments for a period of ten years (investment incentive). Se-curing generation adequacy in the medium-term (availability service) throughcontracts of one year or less with peak-load power plants was the other maintarget. However, to estimate the required generation capacity and long-termcapacity payments was made significantly more difficult by unforeseen eventslike the economic crisis and the resulting low electricity demand, which to-gether led to the reduction of long-term capacity payments for investmentsin 2012 and ultimately to the abolition of the investment incentive in 2013.Nonetheless, the availability service is still active.

3.3. Harmonization of the European electricity marketThe European Commission (2011) considers a single European electricity

market—also termed “internal electricity market”—essential in order to en-sure competitive, sustainable and secure energy supply in the future. This iscontrasted by several European countries already using or currently imple-menting individual mechanisms to increase generation adequacy on a nationallevel (see Section 3.2 and Figure 4a). Yet, the uncoordinated implementa-tion of these local mechanisms might lead to numerous potentially adversecross-border effects, which are described in detail in Section 4.6.

Bearing in mind the additional mechanisms that are likely to be estab-lished within the next few years (see Figure 4b), these potential cross-bordereffects are expected to further gain in importance. For this reason, Hawkeret al. (2017) suggest three different approaches in order to limit potential ad-verse effects of national mechanisms. Firstly, generators could be permittedto participate in CRMs in their neighboring countries taking into accountthe respective interconnector capacity. Secondly, all national mechanismscurrently in operation could be harmonized and coordinated under a singledesign. Thirdly, a single EU-wide CRM could be implemented. However,although a European strategic reserve is described as technically feasible

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by Neuhoff et al. (2016), a realization of the latter two options is unlikelyand potentially also not reasonable due to different drivers for the designof the national mechanisms11 and difficulties in defining a common VoLLdespite countries’ structural differences in terms of their economy, their en-ergy mix and their potential risk of shortage situations (Reseau de transportd’electricite, 2014a).

The European Commission has already recognized the issue of cross-border effects and, thus, continuously assesses the conformity of plannedand implemented mechanisms with EU State aid rules (for an overview ofthe cases see European Commission, 2017d). For a lawful public interven-tion in the market, the European Commission (2013) requires the respectivemember state to demonstrate the essential need for any capacity remunera-tion. Moreover, any mechanism must ensure that distortions of competitionare minimized and technology neutrality is guaranteed. The latter aspect in-cludes the eligibility of demand-side measures or foreign generation capacity,which, for example, has led to several adjustments of the French decentralizedcapacity market mechanism.

4. Impacts on efficiency and market welfareIn the following, the most significant theoretical and model-based studies

along with their key findings are reviewed. First, the design elements ofCRMs (Section 4.1) are briefly discussed. Then, it is examined how CRMsare affected by the current characteristics of the electricity market such asmarket power (Section 4.2), risk aversion (Section 4.3), and investment cycles(Section 4.4). Subsequently, it is discussed how market welfare is influencedby CRMs (Section 4.5) and what effects occur in neighboring market areas(Section 4.6). Finally, the impact of CRMs in a changing electricity marketcharacterized by a higher share of RES (Section 4.7) and a more flexibledemand side (Section 4.8) is discussed.

For many analyses, especially for dynamic long-term effects—such as theoccurrence of investment cycles—the use of models is highly suitable (Hary

11Although the main drivers behind the implementation of a CRM are usually threatsto generation adequacy, the backgrounds may differ, e.g., while Belgium and Germany arephasing out nuclear power and see the need to incentivize new generation capacity, Franceand Sweden cope with potentially system-endangering demand peaks in winter.

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et al., 2016). Numerous different approaches already exist in the literature,which are summarized in Table 4 that also shows the growing interest inelectricity market design.

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a) b)

No CRM Strategic reserve Central buyerTender for new capacity Targeted capacity payments De-central obligation

Figure 4: Overview of a) current situation of CRMs in Europe and b) the status in thefuture when all planned mechanisms are implemented. Already today, the mechanisms arepoorly coordinated, which might intensify due to additional mechanisms being establishedwithin the next few years. Sources: ACER and CEER (2017); EirGrid plc and SONILimited (2017); European Commission (2014, 2016a,b); Hancher et al. (2015); Roqueset al. (2016).

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Table 5: Summarized overview of modeling approaches regarding the devel-opment of electricity market design with a focus on capacity remunerationmechanisms.

Publication Model typea, b Model scope Marketarea

Research subject

Aalami et al. (2010) analytical interruptible technologies Iran impact of capacity market programs onthe load level and shape

Abani et al. (2018) system dynamics spot market, decommissions(retirement of unprofitableexisting generation)/investments

hypothetical impact of risk aversion on theperformances of capacity remunerationmechanisms (competitive EOM,capacity market and strategic reserve)with investors facing an uncertain peakload

Abani et al. (2016) system dynamics spot market, decommissions(retirement of unprofitableexisting generation)/investments

hypothetical impact of investors’ risk aversion oninvestments in generation capacity in acompetitive EOM and a capacitymarket

Assili et al. (2008) system dynamics electricity dispatch, investments hypothetical influence of capacity payments onmarket prices and the reserve margin

Bajo-Buenestado(2017)

analytical (perfectcompetition, subgameperfect Nashequilibrium)

spot market, investments Texas(ERCOT)

welfare effects of introducing capacitypayments in a competitive market anda market with dominant firms

Bhagwat andde Vries (2013)

agent-based (EMLab) spot market, investments,transmission constraints

Germany,Netherlands

effect of a strategic reserve in Germanyon investment behavior and leakage ofreserve benefits to the Netherlands

Bhagwat et al.(2014)

agent-based (EMLab) spot market,decommissions/investments,transmission constraints

hypotheticalbased onGermany

cross-border impact of a capacitymarket and a strategic reserve onconsumer costs and on investments inthe affected markets

Bhagwat et al.(2016a)

agent-based (EMLab) spot market, decommissions(retirement of unprofitableexisting generation)/investments,transmission constraints


effectiveness strategic reserve in thepresence of a high RES share

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Research subject

Bhagwat et al.(2017a)



effectiveness of a capacity market in thepresence of imperfect information anduncertainty, declining demand shocksresulting in load loss, and a growingshare of RES

Bhagwat et al.(2017b)

agent-based (EMLab) spot market, decommissions(retirement of unprofitableexisting generation)/investments

hypotheticalbased on theUnitedKingdom

effectiveness of a forward capacitymarket with long-term contracts in thepresence of a growing share of RES

Bhagwat et al.(2017c)



cross-border effects of a capacity marketand/or a strategic reserve

Briggs and Kleit(2013)

analytical (Ramseyoptimum)

spot market, investments,transmission constraints

hypothetical efficiency of capacity payments

Bublitz et al. (2015) agent-based(PowerACE)

spot market, decommissions(retirement of unprofitableexisting generation)/investments,operating reserve, transmissionconstraints

Germany effects of the proposed strategic reservein Germany on security of supply andcosts

Cepeda and Finon(2011)

system dynamics spot market, investments,transmission constraints

hypothetical cross-border effects of an EOM(with/without price cap) and a forwardcapacity market

Cepeda and Finon(2013)

system dynamics spot market, investments hypotheticalbased onFrance

effects of large-scale deployment of windpower generation on spot prices andreliability of supply

Creti and Fabra(2007)

analytical (perfectcompetition,monopoly)

spot market, transmissionconstraints

hypothetical firms’ optimal behavior and marketequilibrium in capacity markets withthe possibility to sell to a foreignmarket under both perfect competitionand monopoly

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Research subject

Ehrenmann andSmeers (2011)

stochastic equilibrium electricty dispatch, investment hypothetical effects of risk (fuel prices, carbonmarket) on investment decisions ingeneration capacity

Fabra et al. (2011) analytical (Nashequilibrium)

investments hypothetical effects of price caps and auction formats(uniform-price/discriminatory) oninvestments and the capacity ratiobetween two firms

Fan et al. (2012) stochastic equilibrium electricity dispatch, investments hypothetical effects of uncertainty and risk aversionon investments in high and low-carboncapacities

Franco et al. (2015) system dynamics electricity dispatch,decommissions (retirement ofunprofitable existinggeneration)/investments

GreatBritain

effect of central buyer capacity marketon investment cycles and long-termmarket stability

Genoese et al. (2012) agent-based(PowerACE)

spot market, investments,operating reserve, transmissionconstraints

hypotheticalbased onSpain

impact of a capacity paymentmechanism on the long-termdevelopment of investments inconventional capacities and onelectricity prices

Gore et al. (2016) single-firmoptimization

spot market, transmissionconstraints

Finland,Russia

short-term effects of an EOM and anenergy-plus-capacity market oncross-border trade and efficientallocation of transmission capacity

Grave et al. (2012) single-firmoptimization (DIME)

electricity dispatch,decommissions (based onage)/investments

Germany development of security of supply underthe increasing penetration ofintermittent RES and the need forbackup capacity and electricity imports

Grimm and Zottl(2013)

analytical (perfectcompetition, Nashequilibrium)

spot market, investments Germany influence of spot market design onfirms’ investment decision for differentregimes of spot market competition(competitive prices and Cournot-Nashequilibrium)

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Research subject

Hach et al. (2016) single-firmoptimization

spot market, decommissions(retirement of unprofitableexisting generation)/investments

GreatBritain

affordability, reliability, andsustainability of a central buyercapacity market (for new ornew/existing capacity)

Hach and Spinler(2016)

real options for singleinvestor

spot market, investments Europe effect of capacity payments oninvestments in gas-fired power plantsunder rising renewable feed-in

Hary et al. (2016) system dynamics spot market, decommissions(retirement of unprofitableexisting generation)/investments

hypothetical dynamic effects of a capacity marketand a strategic reserve mechanism oninvestment cycles

Hasani-Marzooniand Hosseini (2013)

system dynamics electricity generation,investments, operating reserve,transmission constraints

Iran effect of a (regional) capacity paymentmechanism and a price cap oninvestments in Iranian electricitymarket

Herrero et al. (2015) single-firmoptimization

electricity dispatch, investments hypothetical effects of the implemented pricing rule(linear and non-linear) on long-terminvestment incentives

Hobbs et al. (2007) agent-based (singleagent)

investments hypothetical effects of alternative demand curves inthe PJM market on reserve margins,generator profitability, and consumercosts

Hoschle et al. (2017) analytical(Karush-Kuhn-Tucker)

electricity dispatch, investments,green certificates

Belgium effect of central buyer capacity marketand strategic reserve on the reservemargin and non-participating RES

Jaehnert andDoorman (2014)

single-firmoptimization

electricity dispatch, investments,transmission constraints

Netherlands,Germany

effect of a capacity mechanism or anincreased price cap on generationcapacity under rising renewable feed-in

Joskow (2008) analytical (Ramseyoptimum)

spot market, investments hypothetical sources of the missing money problemin imperfect markets

Joskow and Tirole(2007)

analytical (Ramseyoptimum)

spot market, investments,operating reserve

hypothetical efficiency of capacity obligations

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Research subject

Keles et al. (2016) agent-based(PowerACE)

spot market, decommissions(retirement of unprofitableexisting generation)/investments,operating reserve, transmissionconstraints

Germany generation adequacy in different marketdesigns (EOM, central buyer capacitymarket, strategic reserve)

Kim and Kim (2012) single-firmoptimization

electricity dispatch, investments,transmission constraints

South Korea effects of zonal forward capacitymarkets on investments across marketzones

Laleman andAlbrecht (2016)

statistical electricity dispatch Belgium occurrence of electricity shortages andsurpluses in the presence of a high shareof nuclear combined with a high shareof intermittent RES

Lara-Arango et al.(2017a)

analytical (jointmaximization, Nashequilibrium, perfectcompetition) combinedwith scenarioexperiments

spot market, investments hypothetical economic welfare of a central buyercapacity market and a strategic reserve

Lara-Arango et al.(2017b)

agent-based electricity dispatch,decommissions (based onage)/investments

hypothetical influence of uncertainty on producersurplus and market stability in case ofcapacity payments and a capacityauction

Leautier (2016) analytical (two-stage,Nash equilibrium)

spot market, investments hypothetical optimal investment in different marketdesigns (financial reliability options,physical capacity certificates, singlemarket for energy and operatingreserves)

Le Coq et al. (2017) analytical combinedwith scenarioexperiments

spot market, investments hypothetical relationship between prices, marketpower and investment under threedifferent regulatory regimes (low pricecap, high price cap, capacity market)

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Research subject

Levin and Botterud(2015)

single-firmoptimization

electricity dispatch, investments,spinning-up and non-spinningreserve

Texas(ERCOT)

ability of three different marketmechanisms (Operating ReserveDemand Curves, Fixed Reserve ScarcityPrices and fixed capacity payments) toprovide generator revenue sufficiencyand resource adequacy with increasingamounts of renewable energy

Lueken et al. (2016) statistical spot market PJM resource adequacy requirements in thePJM market area assuming plantfailures are either independent orcorrelated

Lynch and Devine(2017)

analytical(Karush-Kuhn-Tucker)

spot market, decommissions(retirement based on highermaintenance costs)/investments,refurbishment

hypothetical impact of refurbishment under capacitypayments and reliability options

de Maered’Aertrycke et al.(2017)

stochastic equilibrium electricity dispatch, investments hypothetical impact of incomplete risk trading(Contracts for Difference, ReliabilityOptions with and without physicalback-up) on investments

Mastropietro et al.(2016)

agent-based(two-stage)

spot market, investments hypothetical impact of penalty schemes forunder-delivery on capacity mechanisms’effectiveness and unit reliability

Meunier (2013) analytical electricty dispatch, investment hypothetical effect of risk and risk-aversion on thelong-term equilibrium technology mix

Meyer and Gore(2015)

analytical (Nashequilibrium)

spot market, investments hypothetical influence of competition and marketpower on market welfare of CRMs(strategic reserve and reliabilityoptions)

Milstein and Tishler(2012)

analytical (Nashequilibrium)

spot market, investments Israel the rationality of underinvestment ifprofit-seeking, non-abusive producersconstruct and operate either one—baseor peaking—generation unit (or both)

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Research subject

Mohamed Haikel(2011)

analytical (three stage,Karush-Kuhn-Tucker,Nash equilibrium)

spot market, investments hypothetical comparison of three CRM (reliabilityoptions, forward capacity market, andcapacity payments) in regard ofefficiently assuring long-term capacityadequacy in Cournot oligopoly,collusion, and monopolistic situations

Neuhoff et al. (2016) single-firmoptimization

electricity dispatch, transmissionconstraints

hypothetical benefits of coordinated cross-borderstrategic reserves

Ochoa and Gore(2015)

system dynamics electricity dispatch, investments,transmission constraints

Finland,Russia

effects of maintaining a strategic reservein Finland in combination with thedifferent scenarios of interconnectionexpansion and trading arrangementswith Russia

Osorio and vanAckere (2016)

system dynamics electricity dispatch, investments,transmission constraints

Switzerland impact of the nuclear phase-out and theincreasing penetration of variable RESon security of supply

Ozdemir et al.(2013)

single-firmoptimization(COMPETES)

electricity dispatch,decommissions (based onage)/investments, transmissionconstraints

Europe cross-border effects (investments,electricity generation, market prices,and import export flows) of a unilateralintroduction of a German capacitymarket

Park et al. (2007) system dynamics spot market, investments South Korea effects of capacity incentivesystems—loss of load probability orfixed capacity payments—on investmentin the Korean electricity market

Petitet et al. (2017) system dynamics(SIDES)

electricity dispatch,decommissions (retirement ofunprofitable existinggeneration)/investments

hypothetical effects of capacity mechanisms onsecurity of supply objectives assumingrisk-averse and risk-neutral investorbehavior in power markets undergoingan energy transition

30



Research subject

Ringler et al. (2017) agent-based(PowerACE)

spot market, investments,operating reserve, transmissionconstraints

CWEMarket area

effects of cross-border congestionmanagement and capacity mechanismson welfare and generation adequacy inEurope (potential development of theCWE Market)

Schwenen (2014) analytical spot market hypothetical effect of market structure (duopoly withsymmetric and asymmetric firm size) onsecurity of supply in a capacity marketand an EOM

Schwenen (2015) analytical capacity auction New York(ICAP)

strategic bidding to coordinate on anequilibrium in multi-unit auctions withcapacity constrained bidders

See et al. (2016) single-firmoptimization

electricity dispatch, transmissionconstraints

hypothetical reinforcing cross-border competition forthe supply of capacity generation withthe help of a flow-based forwardcapacity mechanism

Tashpulatov (2015) log-linear regression spot market England andWales

effects of regulatory reforms onincentive and disincentive to exercisemarket power

Traber (2017) analytical(Karush-Kuhn-Tucker)

spot market, decommissions(based onage)/investments/retrofitting,transmission constraints

Germany,France, andPoland

effects of capacity remunerationmechanisms on welfare and distribution(consumers/producers) with a focus onconventional power plants

de Vries and Heijnen(2008)

agent-based spot market, decommissions(based on age)/investments,interruptible technologies

TheNetherlands

effectiveness of different market designs(an EOM with and without marketpower, capacity payment, operatingreserves pricing, capacity market) underuncertainty about demand growth

Weiss et al. (2017) hybrid (single-firmoptimization/agent-based)

spot market, investments Israel market prices, reliability, and consumercosts in different market designs (EOM,capacity market, strategic reserve)

31



Research subject

Willems and Morbee(2010)

analytical spot market, investment Germany effects of an increasing number ofderivatives on welfare and investmentincentives in electricity market with riskaverse firms

Winzer (2013) agent-based spot market, investments GreatBritain

robustness of various capacitymechanisms to welfare losses caused byregulatory errors

Zimmermann et al.(2017)

agent-based(PowerACE)

spot market, decommissions(based on age)/investments,transmission constraints

Belgium,Germany,France

effects of a capacity market andstrategic reserve on investments andelectricity prices

a Here, the column “model scope” excludes all CRM as these are mentioned in the column “Research subject”. b If only marginal costs are regarded to determine, whichcapacity is operating, the term “electricity dispatch” is used. However, the term “spot market” is used if the strategic behavior of market participants is explicitly modeled.32

4.1. Generic design criteria for a capacityremuneration mechanism

The design of a CRM is a complex challenge where the ideal solutiondepends on the particular market conditions, e.g., the existing capacity mixand the demand characteristics (Batlle and Rodilla, 2010; Cepeda and Finon,2011; Keppler, 2017; Spees et al., 2013). Thus, in the following paragraphs,the major design elements12 of CRMs are discussed.

Target for system availability

Once the decision to introduce a CRM has been made, a system-wide targetfor system adequacy is often set, which helps to determine in the case ofvolume-based mechanisms the required capacity level or in the case of price-based mechanisms the targeted capacity price (Hogan, 2017). Here, the lossof load expectation (LOLE)13 is frequently used and often a value of 1 dayin 10 years is targeted (NERC, 2009), which however has been criticizedas arbitrary and too strict to be economically optimal (Cramton and Stoft,2006). Taking into account correlated outages among generators and theexpected future demand, then the required quantity of demand to reach thetarget for system availability is derived.

Demand Curve

In quantity-based CRMs, a demand curve—usually referred to as the variableresource requirement demand curve—must be defined that sets the price foreach capacity level.14 Although in theory, it makes sense to rely on the

12At this point only the most important design parameters as well as selected parametersfor specific mechanisms can be discussed, for further criteria, e.g., see Batlle and Perez-Arriaga (2008); Ausubel and Cramton (2010) for different design criteria, Herrero et al.(2015) for pricing rules, Neuhoff et al. (2016) for the design of a strategic reserve orSchwenen (2015) for the design of capacity auctions.

13However, the LOLE is not free of criticism, for example, as it refers only to curtailmentand does not indicate to what absolute or relative extent in relation to the market size thecurtailment occurs. Here, the unserved energy (UE) metric provides more insight (Luekenet al., 2016). An overview of further reliability target can be found at Milligan et al.(2016).

14Instead of demand curves sometimes a fixed capacity is set. However, Hobbs et al.(2007) advise against this practice as sloped demand curves bear lower risks for consumers.

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declining marginal value of capacity (Cramton and Stoft, 2007), in practice,due to the difficulty of estimating this value, usually, a linear curve basedon an upper and a lower price limit is used (Spees et al., 2013). The upperprice cap needs to be high enough to incentivize sufficient investments whenthe system is tight and typically equals a multiple of the Net CONE15. Thelower price cap is usually set equal to zero and marks the capacity level whenthe desired reserve margin is reached. However, sometimes, in order to avoida total price collapse or prevent market manipulation from large purchasersof capacity, a higher price is set, e.g., 75% of the Net CONE (Miller et al.,2012). When setting the upper and lower price limit, it also needs to be takeninto account that a steep demand curve may lead to more volatile prices and,thus, greater uncertainty for investors (Bhagwat et al., 2017b).

Eligible Technologies

In a next step, the definition of the capacity product needs to be established,and it has to be decided which capacity resources are eligible. De Sisternesand Parsons (2016) argue that CRMs should be technology-neutral and al-low for the participation of all elements that can reliably provide capacity(conventional and renewable generation, storage technologies, demand-sidemeasures). If certain technologies were to be excluded, the mechanisms wouldintroduce hidden subsidies for the technologies eligible for the CRM, whichin turn would lead to higher costs for consumers. At the same time, how-ever, it must be noted that this can possibly lead to conflicts regarding thereduction of carbon emissions, for example, in Great Britain highly emission-intensive diesel-fueled generators received capacity payments (S&P GlobalPlatts, 2015). Moreover, Hach and Spinler (2016) propose to consider thespecific policy targets and only consider a technology-neutral selection if gen-eration adequacy is to be achieved at the lowest possible cost. However, ifparticularly flexible capacities are required or an ambitious emission reduc-tion target needs to be achieved, this should be reflected in the selection of

15Similar to the determination of the VoLL, the determination of the CONE or the NetCONE, which is usually carried out by the regulator, is also a controversial matter. Thechoice or the cost-basis of the reference technology, and, thus, its value is often adjustedover time (Cramton and Stoft, 2007, 2008; Jenkin et al., 2016). Regarding the relateduncertainty, Spees et al. (2013) propose to better set a higher value to avoid unreliableoutcomes.

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technologies. Although it is cheaper to only pay for new generation capac-ities, it must be noted that this strategy works only once as investors willadjust their behavior onwards and demand additional protection and riskpremiums (Cramton et al., 2013).

Verification system

In order to enhance the performance of CRMs, a performance incentive sys-tem is required, which ensures that the capacities actually provide the con-tracted capacity when the system is tight (Vazquez et al., 2002; Mastropietroet al., 2016). This can either be implemented through a financial penalty fornon-compliance (Cramton and Stoft, 2005) or by restricting the amount a re-source can provide to its firm capacity (Batlle and Perez-Arriaga, 2008). Theexperiences from the United States show that despite the existence of explicitpenalties, underperformance has occurred, which underlines the importanceof designing and implementing a performance incentive system (Mastropietroet al., 2017). If a financial penalty is chosen, it needs to be high enough toincite investors to compliance, which, however, increases the risk of investorsand this is reflected in their bids. For the exact amount of the penalty, it ispossible to rely on the VoLL, the capacity price or the Net CONE.

4.2. Potential and effects of market powerCentral buyer mechanism, e.g., reliability options, are able to lower the

potential for market power in wholesale electricity markets (Le Coq et al.,2017; Leautier, 2016) and thereby improve the efficiency and reduce the to-tal bill of generation, which is defined as the sum of the revenues realizedby the electricity generators (Hach et al., 2016). By contrast, compared toan EOM, Bhagwat et al. (2016a) claim that a strategic reserve increases thepossibility to exercise market power as the opportunities to withhold capac-ities, which can result in an activation of the reserve and extreme marketprices, become more frequent compared to an EOM where market power isprimarily exercised during capacity shortage hours.

In addition, as Mohamed Haikel (2011) points out, market power mightbe exerted when introducing non-market based mechanisms, e.g., capacitypayments. However, the possible entry of a new competitor makes them lessvulnerable to market power than, e.g., day-ahead markets, where in the shortterm no additional competition can emerge (Schwenen, 2014). Therefore, itseems unlikely that the additional potential of market power within a CRM

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will compensate for the lower potential in the wholesale markets. Nonethe-less, Joskow (2008) advocates that the capacity price could be reduced bythe quasi-rents earned by a hypothetical peaking unit, thereby disincentiviz-ing the exercise of market power. Furthermore, Cramton and Stoft (2008)argue that only new investments could be allowed to set the capacity priceto mitigate market power, existing capacity must either submit a zero bidor is not allowed to participate at all. The rationale behind this approach isthat although established market players might possess market power, theyare unable to exercise it if there is competitive new entry and only newinvestments set the price.

4.3. Influence of uncertainty and risk aversionIn the majority of the considered analyses, it is assumed for simplification

purposes that all decision-makers act risk-neutral, although several theoret-ical arguments (Neuhoff and de Vries, 2004; Banal-Estanol and Ottaviani,2006) as well as real-world observations suggest that decision-makers in theenergy sector are usually risk-averse or at least behave accordingly (Meunier,2013). This seems to be the case not only for economic but also for politicaldecision-makers (Finon et al., 2008; Neuhoff et al., 2016). However, severalstudies explicitly consider risk-aversion and their findings are described inthe following.

As the electricity market reacts very sensitively to the level of risk aver-sion of the investors (e.g., Petitet et al., 2017), risk aversion causes the marketto deviate from the installed capacity in the welfare optimal case (Winzer,2013). Given the high social costs of capacity shortages and the uncertaintyassociated with the development of the electricity market, De Vries and Hei-jnen (2008) point out that the socially optimal level of generation capacityis higher than the theoretical optimum under perfect foresight. Moreover,Ehrenmann and Smeers (2011) find that in an EOM with a low price cap aswell as in a CRM, uncertainty and risk aversion aggravates the generationadequacy problem, which in turn can dramatically increase the costs for endconsumers. This is caused by delaying investments and shifting from high- toless-capital intensive investments. Similar findings are made by de Vries andHeijnen (2008) who state that CRMs can contribute to a more balanced gen-eration portfolio by reducing the investment risk and, thus, counteracting thetendency of risk-averse investors towards low-capital technologies with shortlead times. Fan et al. (2012) conclude that a CRM could prove to be bene-ficial as their findings indicate that risk aversion tempts investors to adopt

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the decisions that would have been taken if the worst-case scenario had ma-terialized thereby avoiding investments in new uncertain technologies, e.g.,concentrating solar power.

As part of an analytical analysis, Neuhoff and de Vries (2004) investigatethe influence of weather- and demand-related uncertainty and risk aversionon the investment decisions of electricity generators having a unique tech-nology at their disposal. Their results indicate that an EOM will provideinsufficient investment incentives to ensure generation adequacy if investorsor final consumers are risk-averse and unable to hedge their portfolio ade-quately via long-term contracts. De Maere d’Aertrycke et al. (2017) analyzethe effect of two reference long-term contracts as well as the impact of along-term forward capacity market and find that even though long-term con-tracts and a highly calibrated forward capacity market are able to improvewelfare substantially, they also entail severe drawbacks. In all cases, tradedvolumes need to be far higher than in current energy markets as illiquiditycan severely impair the effectiveness of these instruments and increase therisk premiums demanded by investors by about 10%. Besides, Willems andMorbee (2010) find that the liquid trade of derivatives provides sufficient in-centives for a risk-averse producer to invest. Here, forward contracts mainlylead to an increase of investments in base-load capacity, and if also optionsare offered in the market, the investments in peak-load plants will increaseas well. In some cases, if no suitable financial substitutes are traded for aninvestment option, however, overinvestment can occur.

Furthermore, Abani et al. (2016) state that considering the risk aversionof the decision makers involved is crucial when comparing different marketdesigns. Their results demonstrate that when comparing the implementa-tion of a central buyer mechanism and an EOM, the difference in shortagesituations increases if investors are regarded as risk-averse instead of risk-neutral. In a more recent study, Abani et al. (2018) investigate an EOMand two CRMs (central buyer, strategic reserve) and find that in case of riskaversion, investors tend to extend the lifetime of existing generation capacityinstead of building new, which in turn leads to higher total generation costs.Similarly, Petitet et al. (2017) show that in an EOM the amount of eco-nomically motivated decommissions of thermal plants or the level of scarcityprices is dependent on the risk aversion of the investors. However, CRMsare comparatively insensitive to the risk aversion of the market participantsdue to the fact that the required quantity is directly specified by the regula-tor and the risk aversion of the market participants is reflected in their bids

37

affecting the total costs. This proves to be a substantial benefit for policymakers as market developments are more predictable.

4.4. Effects of investment cyclesAlthough fixed or variable capacity payments are unable to abolish in-

vestment cycles, they reduce the cycles’ amplitude resulting in a high levelof market price stability and a reasonable reserve margin (Assili et al., 2008;Ford, 1999). Moreover, Cepeda and Finon (2011) demonstrate that invest-ment cycles can effectively be dampened by capacity obligations, in turnleading to smoother annual average electricity prices and higher reliability.

In case of a strategic reserve, Bhagwat et al. (2016a) and de Sisternes andParsons (2016) find that investment cycles, e.g., caused by uncertainty aboutthe future electricity demand, may still occur. Similarly, Hary et al. (2016)show that although underinvestment is avoided, overinvestment is not pre-vented by a strategic reserve as the regulator cannot influence the perceivedvalue of additional generation capacity or enforce investors to postpone theirdecisions. However, a central buyer mechanism is able to positively influenceinvestor behavior and, therefore, reduce the occurrences of under- and over-investment. Moreover, Bhagwat et al. (2017a) find that in case of a forwardcapacity market boom and bust cycles may still occur if the electricity de-mand drops sharply, consequently leading to the decline of capacity pricesand multiple decommissions of existing capacity so that only a high reservemargin initially set by the regulator prevents loss of load situations. In reac-tion to the resulting shortage, capacity prices spike again, and investmentsare made. Similarly, Bhagwat et al. (2017b) state that in a forward capacitymarket investment cycles still exist, but in comparison with an EOM, theyextend over longer periods and feature smaller amplitudes. Also, by decreas-ing the investor risk and reliability risk for consumers, forward reliabilitymarkets can prevent boom-bust cycles (Cramton and Stoft, 2008).

Beyond, Franco et al. (2015) claim that the implementation of a CRMtogether with long-term contracts for low-carbon generators prevent any fluc-tuations in the price and reserve margin in the British electricity market.However, sudden shocks seem not to be taken into account in the analysis.Also, Hasani and Hosseini (2011) state that a hybrid CRM (periodically us-ing capacity payments and a forward capacity market) is able to preventover- and underinvestment efficiently.

In summary, the presented results support the assertion that investmentcycles, which are caused by uncertainties, e.g., regarding the demand growth,

38

can be damped by CRMs (de Vries and Heijnen, 2008). However, most oftenthey cannot be completely prevented and a sufficient reserve margin mainlydepending on market uncertainties needs to be determined by the regulator.

4.5. Efficiency and market welfare of capacityremuneration mechanisms

As a strategic reserve allows the use of all contracted capacities only fora single purpose, inevitably inefficiencies occur, and additional investmentsare needed to replace the lost flexibility (Hoschle et al., 2017). Further,the dispatch of the strategic reserve at any other value than the VoLL canreduce the market welfare analogous to the price caps in the EOM (Finonet al., 2008). Besides, a strategic reserve does not appear to improve themarket stability or increase the expected economic surplus in the long term(Lara-Arango et al., 2017a). Therefore, it seems advisable to use a strategicreserve as a short-term solution and replace it by other mechanisms in thelong term. However, the distributional effects of strategic reserve seem to berelatively small (Neuhoff et al., 2016).

Creti and Fabra (2007) state that in order for a CRM to maximize so-cial welfare, gains from reducing load loss situations must exceed the ad-ditional capacity costs and the secured capacity procured should be equalto the peak demand. Furthermore, they argue that the price limit shouldbe defined as the opportunity costs of providing full capacity commitmentas different parameterizations would lead to a reduction in welfare througheither overcapacities or scarcity prices. In a case study for Great Britain,Hach et al. (2016) find that through deliberate overcapacity and, thereby,avoiding extreme prices and lost load occasions, a central buyer mechanismcan effectively lower the total bill of generation. Similar results are obtainedby Bhagwat et al. (2017b), Hoschle et al. (2017), and Keles et al. (2016) incase studies of the electricity market in Great Britain, Belgium, and Ger-many respectively. However, Schwenen (2014) argues that in a frameworkwith two firms, in equilibrium capacity prices are non-competitive due tocapacity constraints and signals for the entry of new firms are likely beingdistorted by the regulator.

By employing an analytical model, Briggs and Kleit (2013) find that ca-pacity payments for base-load power plants are never optimal. In the shortterm, capacity payments will cause prices to fall and competitive base-loadpower plants to be suppressed, and in the long term incentives to invest

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in peak load power plants and generation adequacy will decline. Also, thepositive short-term price effect might be lower than theoretically expected(Genoese et al., 2012), and the payments might even fail to ensure an ad-equate reserve margin (Park et al., 2007; Kim and Kim, 2012). Likewise,Milstein and Tishler (2012) find that targeted capacity payments for thepeaking technology, which account for 25% of the associated capacity costs,only increase the social welfare by 0.02%. Furthermore, Bajo-Buenestado(2017) show that the benefit of capacity payments depends on the intensityof competition and is less if the market is controlled by dominant companiesas in many real-world markets. Joskow and Tirole (2007) state that if marketpower is present in a market with more than two states of nature, i.e., peakand off-peak, capacity payments are an insufficient instrument.

As results from the literature are not always coherent and often onlyapplicable for specific cases, the question of which CRM is most efficient re-mains open. For example, often a central buyer mechanism seems to yieldsignificantly better results than a strategic reserve (Hary et al., 2016; Keleset al., 2016; Hoschle et al., 2017), but sometimes the results are ambiguous(Traber, 2017). Most likely, this can be attributed to the fact that the re-sults depend among other things on the existing generation structure andtheir development in time (Batlle and Rodilla, 2010; Traber, 2017) as well asthe taken assumptions, e.g., the consideration of uncertainty (Lara-Arangoet al., 2017b) or the risk aversion of investors (Petitet et al., 2017). Never-theless, there seems to be a consensus in the literature that market-basedmechanisms are usually advantageous compared to interventionist mecha-nisms, e.g., capacity payments (Batlle and Rodilla, 2010; Mohamed Haikel,2011; Lara-Arango et al., 2017a).

4.6. Influence on neighboring countries throughcross-border effects

One of the difficulties encountered in the study of cross-border effects isthe large number of influence factors such as the regarded markets, gener-ation technologies, different interconnector capacities or asymmetric marketsizes. Furthermore, cross-border effects are strongly influenced by competi-tion between market participants and the possibility of exerting market power(Meyer and Gore, 2015). Thus, deriving common conclusions is extremelychallenging.

One major short-term cross-border effect is the occurrence of market dis-

40

tortions if a CRM does not adequately consider generation capacities abroad.In this case, through additional capacity payments, domestic producers gaina competitive edge over foreign producers (Hawker et al., 2017). However,the primary focus of the scientific research is on long-term effects, i.e., thedevelopment of generation adequacy, distributive effects, and price effects,as CRMs will mainly drive investment decisions (e.g., Ozdemir et al., 2013).For example, with the help of an agent-based electricity market model Bhag-wat et al. (2014, 2017c) find that in case of a forward capacity market andstrategic reserve in two neighboring markets, the forward capacity marketappears to have a negative spillover effect on the strategic reserve. However,a neighboring EOM does not limit the ability of a national forward capacitymarket or strategic reserve to achieve its objectives. Indeed, vice versa, twoeffects can be observed. On the one hand, the neighboring EOM operatesas a free-rider and benefits from the additional foreign generation capaci-ties. On the other hand, the dependence of the EOM on imports increases,which can be particularly disadvantageous in critical situations. Similar re-sults are obtained by Ochoa and Gore (2015), who show in a case studyfor the Finnish and Russian electricity market, that if Russian imports werereliably available, abolishing Finland’s strategic reserve could lead to lowercosts for Finnish consumers. However, as this is not the case, the advan-tages of maintaining a strategic reserve outweigh the disadvantages, and theinterconnection expansion should be avoided—instead, the development oflocal capacities should be given preference. Furthermore, Cepeda and Finon(2011) find that in the long-term an EOM will only marginally benefit from aCRM in an adjacent market. Also, for the EOM, the unilateral introductionof a price cap leads to a reduced level of security of supply as suppliers preferto offer their generation capacity in neighboring markets. Moreover, by usinga simulation model to investigate the unilateral introduction of a strategicreserve and reliability options in a two-country case, Meyer and Gore (2015)show that the overall cross-border welfare effect is most likely negative.

In addition, it can be concluded that the introduction of a CRM in aneighboring country creates considerable pressure on the national regulatorto introduce a dedicated CRM as a safeguard against possibly harmful con-sequences (Bhagwat et al., 2017c; Gore et al., 2016). Therefore, Hawkeret al. (2017) are advocating the cross-border coordination of CRMs to pro-vide sufficient new investment in generation and transmission capacities andNeuhoff et al. (2016) claim that a coordinated strategic reserve in Europeshould be feasible and, among other things, would have the following ad-

41

vantages: On the one hand, capacities from abroad could be used at timesof maximum stress and, on the other hand, the joint calculation of the re-serve volume would reduce the required quantity as individual demand peaksusually occur at different times. Furthermore, with the possible expansionof cross-border capacity and the associated strong influence on prices (Oso-rio and van Ackere, 2016), a coordinated approach seems to be increasinglyadvantageous. However, solving the dilemma of choosing between a coordi-nated or national approach is complex. Especially when time is a criticalfactor, a co-ordinated solution might not be implemented early enough dueto the increased need for coordination (de Vries, 2007).

4.7. Impact of a high share of intermittent renewablesOne of the central questions associated with the rapid expansion of RES

is whether they exacerbate the adequacy problem. First of all, Cramtonet al. (2013) point out that price caps present in most EOMs are unaffectedas the level is neither lowered nor increased by RES. Nonetheless, increasinglow price caps might become more relevant as large investments in peak-loadgeneration capacity are likely to be required as a backup for intermittentRES. However, this could be prevented by a price cap set too low (Cepedaand Finon, 2013; Jaehnert and Doorman, 2014).

As RES, due to their marginal costs close to zero, can be regarded asa price-inelastic demand—with the exception of situations where the pricesare negative—Cramton et al. (2013) argue that RES increase the volatilityof and the uncertainty about the demand and market prices and, thereby,exacerbate the adequacy problem. Similarly, Newbery (2017) claims thata high share of intermittent RES, on the one hand, and the uncertaintyabout the development of the carbon allowances price, on the other hand,likely require long-term capacity contracts—beyond a horizon of three to fouryears—for ensuring reliability efficiently.

Jaehnert and Doorman (2014) investigate the development of system ade-quacy and find that the capacity reserve margins decrease with an increasingshare of RES leading to several occurrences of load curtailment. Also, themerit-order effect caused by large-scale employment of wind energy is morerelevant in an EOM than in a market with a CRM, where thermal genera-tion capacities are better able to recover the fixed costs of their investment(Cepeda and Finon, 2013). However, in reverse, a CRM that only takesinto account the secured available capacity can have a negative impact on

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the market-driven development of wind power. Still, in a world with 100%renewable energy, Weiss et al. (2017) argue that an EOM can adequatelyfunction if market prices take into account the opportunity costs of flexibleresources. However, in such a scenario, RES probably still require a dedi-cated funding mechanism. Besides, a CRM might be necessary to minimizethe associated risk of underinvestment in flexible capacities.

4.8. Incentives for flexible resourcesAs with increasing shares of RES supply fluctuations in the electricity

market become more frequent, flexible resources are required (Nicolosi, 2010;Grave et al., 2012), e.g., demand-side management or short-term and long-term storage options that have not yet been sufficiently remunerated in themarket design to date (Cepeda and Finon, 2013; Joskow, 2008). An ade-quate market design needs to pay sufficient attention to flexible resources inorder to fully capitalize on their potential (Neuhoff et al., 2016; Weiss et al.,2017). Although flexible resources do not automatically guarantee a reliablelevel of investment, they ensure reliability under different levels of installedgeneration capacity and induce an efficient electricity dispatch (Cramton andStoft, 2005).

Whereas the concept of firm or reliable capacity is already well definedand, moreover, constant, regardless of how the future electricity system devel-ops, the term flexibility is still vague and furthermore has a critical temporaldependency. Sometimes flexibility is required for a few seconds or minutes,but other times for several hours or even days and usually the most suitableoptions for short-term flexibility are not coherent with those for long-termflexibility (Hogan, 2017). In order to reliably determine the need for andvalue of flexibility, it is best to compare the value of energy in scarcity withthat in abundance situations, which depends on the current state of theelectricity system.

In a well-functioning EOM, market participants are exposed to extremelyhigh price signals at times of scarcity or negative prices in times of oversupply,thus, creating incentives for long-term investments in storage technologies aswell as incentives for consumers to directly react to price developments (e.g.,Hu et al., 2017). For this reason, EOMs can especially benefit from increasedflexibility, e.g., through demand response, as the market is then able to reactto extreme price peaks and consumers are no longer exposed to the excessivemarket power of suppliers, thereby reducing the need for regulatory price

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caps (Schwenen, 2014). Yet, if the market design is severely different, e.g.,by a forward capacity market, price spikes will decrease in frequency andamplitude, thus, diminishing the value of flexible resources (Hogan, 2017).Auer and Haas (2016) even argue that the introduction of capacity paymentsruins market competition, meaning that flexibility options would not be ex-ploited, thus, leaving their development only in the hands of the regulator.Even though these theoretical findings pose a clear disadvantage for CRMs,practical experiences indicate that decision makers seem to be aware of thisissue as, for example in the USA, CRMs explicitly include financial supportfor flexible resources, which in turn lead to a rise of these capacities (Riouset al., 2015).

5. Conclusions and policy implicationsElectricity markets are in many respects similar to most other markets;

however, they require a specific regulatory framework due to a number of pe-culiarities such as the physical characteristics of the commodity electricity, aninelastic volatile demand and the missing-money problem. In combinationwith the ongoing transformation from a centralized system with primarilyfossil-fuel power plants to a decentralized system with a high share of re-newable energies and the sharp decline in electricity prices, concerns amongpolicy makers about generation adequacy have grown and led to the imple-mentation of various CRMs. However, the necessity of CRMs remains thesubject of ongoing discussion, and it is often argued that an EOM alreadyoffers an efficient solution whereas CRMs tend to be inefficient. To bettergrasp the arguments of both sides, afterward, an up-to-date overview of thedebate was given. Subsequently, a classification of the different mechanismswas shown, the current status of implementation in Europe was presented,and initial experiences were discussed.

Although CRMs can improve generation adequacy, they also bring withthem new challenges. One major advantage of CRMs is that they are able toeffectively reduce or even to solve different problems of existing markets. Forexample, fluctuations caused by investment cycles can be dampened—eventhough usually not fully abolished—and, thereby, extreme scarcity eventscan be prevented. Also, the adverse effects of the abuse of market powercan be mitigated, and some mechanisms, for example, a forward capacitymarket, are able to solve the missing money problem. Also, CRMs usually

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make market developments less dependent on the risk profile of the investors,thereby, making them more predictable and reducing deviations from thelong-term optimum that can be caused by risk-averse decision-makers.

Determining the optimal market design, however, remains a complex chal-lenge. As the adequate design depends on a variety of factors such as theexisting capacity mix and demand characteristics, no general advantageous-ness of single mechanisms could be determined so far. For example, oftena central buyer mechanism seems to yield significantly better results than astrategic reserve, which is inefficient by design as contracted capacities areused for a single purpose only. However, in exceptional cases the resultsare ambiguous. Nevertheless, it can be concluded that market-based mech-anisms, e.g., a forward capacity market, are usually advantageous comparedto interventionist mechanisms such as capacity payments.

Furthermore, the implementation of a CRM can lead to market distor-tions, e.g., through cross-border effects. Even though the cross-border im-pacts of CRMs are complex and sometimes unambiguous, there seems to be aconsensus that a one-sided implementation leads to negative spillover effectson a neighboring market without a CRM, which thereby increase the pres-sure to either introduce an own CRM or to chose a coordinated approach.Compared to an EOM, the value of flexible resources that is closely relatedto volatile prices is diminished in the presence of a CRM. Therefore, theirexpansion is largely independent of market forces and left in the hands of theregulator.

Even though a large number of studies has already been carried out, thecomparability of the results is often limited and, thus, it is difficult to selectthe best mechanism to implement. It would therefore be helpful if commoncriteria or specific scenarios are used to evaluate different market designs.Furthermore, especially the efficiency of the mechanism is all too often ne-glected. Also, the behavior of market participants as learning, risk-averseagents that interact with each other often does not seem to be adequatelyaddressed and rarely verified by studies or experiments. However, as theinvestors’ risk profile can directly influence the results and the relative ad-vantageousness of different CRM, it would thus be advisable to explicitlyconsider risk aversion.

AcknowledgementsThe authors acknowledge the financial support of the European Union’s

Horizon 2020 research and innovation programme under grant agreement

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number 691685 as well as the support of the German Federal Ministry forEconomic Affairs and Energy under grant number 0324002A.

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http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.369.6388&rep=rep1&type=pdf

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.369.6388&rep=rep1&type=pdf

https://publikationen.bibliothek.kit.edu/1000065978

https://publikationen.bibliothek.kit.edu/1000065978

http://dx.doi.org/10.1287/opre.1100.0836

www.iip.kit.edu

Impressum

Karlsruher Institut für Technologie

Institut für Industriebetriebslehre und Industrielle Produktion (IIP)

Deutsch-Französisches Institut für Umweltforschung (DFIU)

Hertzstr. 16

D-76187 Karlsruhe

KIT – Universität des Landes Baden-Württemberg und

nationales Forschungszentrum in der Helmholtz-Gemeinschaft


No. 27, February 2018

ISSN 2196-7296

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A survey on electricity market design: Insights from ...

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